It's hard to really like the mortgage real estate investment trust (mREIT) sector right now. The Federal Reserve is about to begin trimming its purchases of mortgage-backed securities, and that will be a headwind for the entire sector.
That said, there are some mortgage REITs that are more focused on mortgage origination, and these stocks should be more insulated than the rest due to a change in the rules out of the Federal Housing Finance Agency. The first one is New Residential (NYSE: NRZ), and the second is Redwood Trust (NYSE: RWT).
While the Fed has consistently said that it is nowhere near raising the Fed Funds rate, it is ready to trim its purchases of Treasuries and mortgage-backed securities. The Fed mentioned in its July Federal Open Market Committee (FOMC) minutes that it has become concerned about the rapid pace of home price appreciation and whether its purchases of mortgage-backed securities is exaggerating the moves.
Jerome Powell said at the Jackson Hole, Wyoming meeting that the economy has made enough progress on unemployment and inflation to begin reducing asset purchases (in other words, Treasuries and mortgage-backed securities). He anticipated that the process could begin by the end of the year.
In 2013, the Fed was in the same position and began reducing asset purchases at the end of 2013. The mortgage REIT sector as a whole underperformed, and agency REITs like AGNC Investment Corp. and Annaly Capital cut their dividends and saw big declines in book value. While the Fed probably won't be as aggressive cutting asset purchases this time around, the Fed will remain a headwind for agency REITs going forward.
Here's some information investors should consider about the two mREITs we're recommending for September.
New Residential is a combination mortgage REIT and mortgage originator. Historically, the company has focused primarily on mortgages that cannot be insured by the government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. These loans were called non-qualified mortgages (Non-QM), and they are a growing part of the mortgage market.
Non-QM mortgages have nothing in common with the subprime mortgages of the mid-2000s. These are often targeted toward professional real estate investors or self-employed individuals without W-2 income. New Residential is a big player in this space, and non-QM lending should be relatively insensitive to the Fed's buying of agency MBS. While New Rez does have exposure to agency lending and holds agency mortgage-backed securities, it will be more insulated than the typical agency REIT.
The best thing about New Residential is that it is undervalued on a sum-of-the-parts basis. New Rez is trading below its $11.27 book value per share, which is largely made up of the company's mortgage-backed securities portfolio. The Street is assigning little to no value to the mortgage origination arm, and that provides some downside protection to the investor. New Rez recently bumped up its dividend and yields 9.2%.
Redwood Trust is primarily involved in lending to borrowers who buy expensive homes and therefore have loan amounts that are too large to be insured by the GSEs. These are called jumbo mortgages in the industry. Since they are not guaranteed by Fannie Mae or Freddie Mac, they will be largely unaffected by the Fed's activity in the MBS market.
According to the Federal Housing Finance Agency, house prices rose at a 17.4% annual rate in the second quarter of 2021. As house prices get more expensive, less will fit in Fannie Mae and Freddie Mac's loan limits, which means more opportunities for Redwood.
Second, the market for non-government-guaranteed mortgage-backed securities seems to have finally recovered at long last, which will give Redwood the ability to push through more volume.
Redwood stock has been on a tear, rising 73% over the past year, while agency REITs like Annaly and AGNC are up in the high-teens range. It pays a 5.8% dividend and trades slightly above book value, which is a function of the origination business.
The Millionacres bottom line
The upcoming months will probably be difficult for the entire mortgage REIT sector, as Fed worries will weigh on the sector. That said, some stocks will be less affected than others. The ones with a focus on non-agency origination will probably perform better than the rest of the sector.